Investing for the long term has many benefits. By identifying
the stocks that will have bright prospects for years and even
decades, you can maximize your chances of earnings explosive
gains for your investment portfolio. Another big benefit of
holding on to your stocks longer is that the IRS rewards
long-term investors with reduced capital-gains taxes for
investments held longer than a year.
Despite your best intentions, though, you'll sometimes find
yourself wanting to sell a stock before you get past that
one-year mark. If you already have paper profits on that stock,
you'll face a tough decision: Should you sell now and pay higher
taxes, or hold out for the lower long-term capital gains rate and
hope the stock doesn't drop in the interim? Let's take a closer
look at how you should think about that critical decision and the
risks and rewards it entails.
Why long-term capital gains are such a big deal
Ordinarily, most investors prefer not to focus on tax
considerations in making their investments. When you invest in an
IRA or other tax-deferred account, you don't
to think about taxes, and that frees you to make buy and sell
decisions irrespective of how long you've owned a stock.
But for taxable accounts, the difference in taxation of
capital gains is truly huge. For taxpayers in the highest income
brackets, each $100 of capital gains can cost you $39.60 in
regular income taxes plus another $3.80 from investment-income
surtaxes, adding up to a 43.4% rate on short-term gains. By
contrast, the top tax rate on long-term capital gains is 20%, and
although the 3.8% surtax on investment income still applies, a
little patience can cut your tax bill almost in half.
Source: John Morgan via Flickr.
Moreover, you shouldn't conclude that only wealthy taxpayers
benefit from long-term capital-gains rates. Those who are in the
10% or 15% tax brackets generally pay their regular rate on
short-term gains, but they don't have to pay any taxes
on long-term capital gains so long as they remain in those tax
brackets. Above that level, the 15% maximum rate on long-term
gains for all but top-bracket taxpayers compares favorably with
the 25% to 35% rates that apply to regular income and short-term
Finally, some states have their own beneficial rates for
long-term capital gains. In Massachusetts, for instance,
long-term gains get taxed at the ordinary 5.2% rate, but
short-term gains pay a higher 12% tax.
Finding the right balance between risk and reward
Ordinarily, these huge potential tax savings make holding a stock
for the long run a smart move. But occasionally, you'll quickly
earn a big paper profit on a stock just months after you buy it,
and the resulting high valuation might make you nervous about
hanging on to it long enough to pay lower long-term capital-gains
taxes when you sell.
Source: Wikimedia Commons
Resolving that dilemma doesn't have to be complicated, though.
In general, if the reason you bought the stock hasn't changed,
then even sizable short-term gains are usually just the tip of
the iceberg compared to the long-term returns you're hoping to
achieve. Selling early might make you feel good to lock in a
quick gain, but it doesn't just boost your immediate tax bill; it
can also lead you to miss out on a much larger long-term rise in
the share price in the years to come.
On the other hand, if the fundamentals of a stock or other
investment have changed, then selling early can mean the
difference between earning
profit on your stock and suffering a loss. During the tech bust
of the early 2000s, for instance, many investors were reluctant
to sell highflying Internet and technology stocks because of the
admittedly large tax bills they would have incurred by selling.
In the process, though, many waited too long and ended up losing
all of their gains and then some. It's always better to earn
income that will be taxed than it is to give up that income
Overall, the incentive to hold on to investments long enough
to benefit from lower capital-gains taxes on long-term holdings
makes it worth thinking twice before selling quickly, as it
really is usually worth it to wait. But if a truly game-changing
situation comes up, don't hesitate to pull the trigger on a sale
-- it can save you from even more costly losses.
Take advantage of this little-known
Recent tax increases have affected nearly every American
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Long-Term Capital Gains: Is It Worth It to
originally appeared on Fool.com.
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